What's the difference between a hedge fund and a mutual fund?

The financial industry continually reinvents itself. A significant part of that process involves the creation of investment vehicles aimed at making money for both the people who create them and the people who buy them. Hedge funds are an investment vehicle that has received a fair bit of press over the past few years. What is the difference between a hedge fund and a mutual fund from the perspective of the lay investor? What they share in common is that both are a fund of pooled assets. By working in aggregate, investors are able to realize greater absolute gains. They differ in their philosophical approach to investment, their toler- ance for risk, and the manner by which they are regulated by govern- ments through their securities and exchange commissions.

WHAT'S OLD IS NEW AGAIN

The suggestion that hedge funds are new is erroneous. Hedge funds first came in to existence in their initial iteration in the raging markets of the 1920s, just before one of the most notorious market crashes at the end of that decade. Although the modern hedge fund may vary drastically in its structure from its forefathers and peers, a study of the investment philosophy and an understanding of the premise behind hedging serves as a great stepping stone to understanding some of the more sophisticated investment approaches available to an investor, and the basic concepts and terminology that lie at their root.

"I LIKE TO HEDGE MY BETS"

Everyone is intuitively familiar in theory with the meaning of this everyday expression. How exactly does that premise weave its way into a pooled asset investment? Hedging in the markets is a way of limiting risk. In one sense, you can think of a hedge as a form of insurance. An investor or fund manager makes a wager that a stock is going to go up. There is no guarantee this will happen and, to limit the downside of the wager, he or she makes another wager to limit exposure to loss.

Everything comes at a price. The cost of mitigating the risk of loss through hedging lies in the limits the hedge puts on profit. You may not lose as much if things go bad, but you also will not make...